SLI's Ennett: 'Yields more' does not equal 'cheap' for bonds
So far in 2015, the European High Yield market has defied many in outperforming that of the US. Many had believed that the dislocation in US High Yield widely blamed on slumping oil prices at the end of 2014 would leave room for it to outperform Europe in 2015. Like many, we looked at this dislocation – after all the two markets had been highly correlated over their relatively short lives – as a potential opportunity. However, when we examined the US market in greater detail, we found that once the differences in composition had been taken into account, far from being cheap, we found it still to be expensive compared with Europe. Even more surprisingly we find this still to be the case.
It raises an important point we feel is often missed in bond market discussions; ‘Yields more’ does not equal ‘cheap’. We see too many analysis comparing markets break down into a banal description of differing yields available. To be blunt, US High Yield yields more than European High Yield but this does not mean it is ‘cheap’; it yields more because it should.
The US market references a higher rate regime – the US Treasury complex, and is longer duration than the European market. This Government or ‘time value of money’ element demands a higher yield. This is before even considering that in all likelihood, the Fed is much closer to raising rates than a still-supportive ECB, and we’d argue an additional risk premium is warranted.
A further consideration is the much higher amount of default risk in the US. The proportion of B and CCC-rated credits is 58% in the US vs 38% in Europe, significant as the probability of default increases exponentially as you move down categories. The underperformance of US High Yield was as much to do with poor underwriting and higher credit risk as with the move in oil prices.
Against this, European High Yield has performed well as the ECB’s QE programme combined with a slowly recovering economy has supported the market. For us, European High Yield has about the right balance of excess yield, but without an excess credit risk which can hurt portfolios in times of stress. Of course, there are some weak Euro High Yield credits (Abengoa being the most recent example) and therefore good stock selection remains paramount whatever the market you invest in.
David Ennett, Head of European High Yield, Standard Life Investments
- ECB much earlier in monetary policy cycle with QE still in progress
- Slow growth and weakened Euro supportive of European High Yield companies themselves
- Still very small proportion CCC issuers (6%).
- Low absolute levels of yield have reduced the attractiveness
- Potential for a handful of large defaults to impact sentiment
- Exposure of some companies to a pronounced slowdown in China
- Liquidity remains challenging
First published by Investment Week 25 September 2015